Importance and limitation of profitability ratios

Overview:

Profitability ratios are a group of quantitative values that measure a company’s profitability against its revenue, cost of sales, equity, and balance sheet assets. It is a metric that measures a company’s ability to generate income from its operations over a specific period of time.

Profitability ratio is a category falling under financial ratios that are used by investors, bankers, financial institution, creditors and other stakeholders for evaluation of financial performance of the company in regards of annual profitability.

These ratios help them to assess how profitable an entity currently earns from using or managing the existing resources to generate profits and add value to its shareholders or owners.

For example, the gross profit margin is the ratio used to assess how efficiently the company manages its costs compared to its competitors or industry averages.

If the margin is high competitors’, it means that the company could generate high profit from 1 USD that it spends compare to competitors or industry averages.

Even though these ratios are importance for most of key stakeholders, that ratios themselves also have the limitation.

In this article, we will discuss the key importance and limitation of profitability ratio that might help analyst or users for their interpretation and usages.

But, before heading to the key importance and limitation, let see the list and formula of ratios first.

List and Formula:

The following is the list of a few ratios that are included in the category of profitability ratios:

Gross profit margin ratio = (Gross Profit / Revenue) * 100

Net profit margin ratio = (Net Profit / Revenue) * 100

Return on equity = (Profit after tax / Shareholder’s equity) * 100

Return on capital employed = Profit before interest and tax / (Total assets – current liabilities)

Return on assets = Profit before interest and tax / Total net assets

A high profitability ratio as compared to the previous year’s performance or the industry in general is an indication of improvement in the profits earned by the company.

On the contrary, though, a low profitability ratio as compared to the previous year’s or the industry in general is an indication of a reduction in profits earned in the current year.

Importance of profitability ratios:

Here, we will discuss the significance of profitability ratio in terms of each ratio mentioned above.

  • Gross profit margin is a measure of the profit earned on sales. It denotes the profit part of the total revenue earned after deducting the costs of goods sold. It is significantly important since the gross profit is what covers the admin and office costs and the dividends to be distributed to the shareholders. The higher the gross profit the more profitable the company is and is a good catch to invest in. As mention above, it is also used to assess the efficiency of cost management. If the calculation shows that the ratio is now, then the key areas to look or improve are purchasing as well as productions in terms of economy and effectiveness.
  • The net profit margin is the final ratio that demonstrates the overall performance of a company. We could say that it is the most important ratio for the management since any disturbances in other ratios indirectly hit the net profit margin as well. For example, a low quick ratio may be because of low sales which would obviously lower the net profit margin as well. This ratio is important since it could help the company or investors to see where it could go wrong in the company’s current operating expenses. Maybe the interest expenses are too high due to the financing strategy that weighs more to loan rather than equity.
  • Where the net profit margin is an important metric for the company itself, returns on equity are one of the most important ratios for the investors. It is a percentage of the earnings the shareholders get in return for the money invested in the company. The higher the ROE means the higher the dividends the shareholders will receive and hence, more investors are attracted.
  • Returns on capital employed (ROCE) measures how efficiently the company uses its assets. It helps the management minimize inefficiencies by evaluating the ROCE ratio. The higher the ROCE as compared to other industries, the higher the efficiency in the production process of the company.
  • Return on assets (ROA) is a measure of every dollar of income earned on every dollar of the asset owned by the company. It is similar to the ROCE and helps the management in managing the utilization of assets.

Limitations of profitability ratios:

  • The profitability ratios like, the net profit margin is not an “evergreen” ratio that can be used to compare profitability amongst various industries. For example, a tech-savvy company has a higher net profit margin compared to a bakery.
  • The value of investment and profit can easily be manipulated to increase or decrease the profitability ratios as per their needs which can be misleading for the investors and stakeholders.
  • The ratios are dependent on several calculations made behind each value reported on the financial statements. A material error or fraud in a line item will result in a miscalculated ratio which would be hazardous for investors and companies in the future.
  • Ratios may also be high or good due to the chance factor and hence, shouldn’t be followed religiously. The context behind ratios must always be checked to confirm with the analysis.

Profitability Ratios Analysis: Example | Types | Explanation | Importance

Profitability Ratios are the group of Financial Ratios that use for assessing and analyzing the entity’s profitability through various ratios.

The areas that these ratios focus on are sales performance, costs management, assets efficiency, and sometimes cash flow management.

The high or increase of these ratios implicitly means the entity financial performing well.

he high or increase of these ratios implicitly mean the entity financial performing well.

These ratios are normally included whether assessing and analyzing profitability ratios:

  1. Gross profit margin
  2. Net profit margin,
  3. Return on assets,
  4. Return on investment,
  5. Return on capital employed and
  6. Return on equity.

In performance management, performance assessment, and/or investments analysis, we normally use some of theses ratio along with others ratios and non-financial indicators to measure and assess the performance, financial position of the entity.

In this article, we list all of the Importance Profitability Ratios that you should know along with the deep analysis of individual ratios.

By the end of this article, you should be able to understand and be able to interpret six importance profitability ratios. We explain the principle of each ratio, including formula and all importance factors that you should know.

Related: Liquidity Ratios Analysis

Here is the detail of  each Profitability Ratios for Financial Analysis:

Gross Profit Margin:

Gross Profit Margin is the Profitability Ratios that use to assess the proportion of gross profit over the entity’s net sales. The main purpose of this ratio is to control the gross profit or cost of goods sold of the entity.

Gross profit margin is calculated by Gross Revenue generates during the period less Cost of Goods Sold.

Now, why do we say that gross profit is not just only measure the Profitability, but also Control Cost?

Well, most of the cost controller and financial controller use this ratio to analyst how well the company controls its cost compare to the competitors.

let say A and B sell the same product and the same price in the same market. Gross Profit Margin of A is 50% and the Gross Profit Margin of B is 60%.

Since it is the same product, we expected that both companies should have the same cost. But in this example, A must spend hither cost than B that is why it’s Gross Profit Margin is smaller than.

Net Profit Margin:

Net Profit Margin is one of the Profitability Ratios that use to measure and assess the proportion of an entity’s net profit after reducing the operating expenses. Another main purpose of the Net Profit Margin is to control company Operating Expenses.

Let move to detail, the Net Profit Margin is calculated by comparing Net Profit to Gross Sale. So, Net Profit is come up by removing the Gross Profit with corresponded operating expenses.

If we first look at this ratio, I think you will come up with the idea that this ratio is used to measure the net profit. But it is not the case.

This ratio is just like Gross Profit Ratio. It comes up as the result of the financial performance indicator and most of the financial analysts when they analyze the Net Profit Ratios, they want to assess Operating Expenses.

For example, if the company got better Gross Profit Ratios, then the main reason is their operation is not effective and efficient. As a result, reviewing the operating activities is the most recommended.

Yet, just recommending to review the current operation is not what most of the management need. You need to do deep recommendations by doing deep analysis.

For example, breakdown the main expenses items and review them if there any room to improve.

Return on Asset or Return on Fixed Asset:

Return on Assets or Return on Fixed Asset is one of the Profitability Ratios that use to assess the level of profit that assets could generate.

Still doubt?

Right?

Let move to detail.

Let talk about a suitable situation to use this ratio.

Return on Assets is right for the Production company that most of its assets are fixed assets, and it is not right to use in the service company like audit firms.

Why?

Because this ratio is used to measure the performance of the assets in terms of profit.

When you interpret Return on Assets or Return on Fixed Asset, you are not only saying about the result of your calculation, but the nature of assets (How old the assets are? ), and probably, staff using the assets.

The performance of assets is not mainly because of the assets themselves. What if the assets are old and management does not replace the spare part and the maintenance schedule is not right.

Return on Fixed Assets is very important to use with Return on Capital Employed if you set up the Financial Performance Indicators for your company.

The main reason is when you use the Return on Capital Employed in Performance Measurement, the ratios will be increased when the assets become old as the result of management intention not to replace them.

Therefore, use both Return on Fixed Assets and Return on Capital Employed will help you to balance.

Return on Investment

Return on Investment is one of the Profitability Ratios that use to assess the profitability that generates from the investments for the period of time from total investments found.

The investment fund is the fund that investors injected their investment found into the project or company.

In most of the case, Return on Investment is used to assess the investment project or products the company launch rather than assess the performance of an entity.

If we want to assess the performance of the entity, then ROC or ROE would be better to use and the most relevant than.

Return Capital Employed

Return on Capital Employed is one of the Profitability Ratios that use to assess the profit that the company could generate for its shareholder’s capital employed. Capital employed is the fund that shareholders inject to the company plus other capital and long term debt.

Capital employed can be calculated by total assets less current liabilities. Sometimes, the entity wants to improve this ratio by using old assets to pay a dividend by using load and buy back shares.

Return on Equity

Return on Equity (ROE): is one of the Profitability Ratios that use to measure how much profit an entity could generate from shareholders’ Equity. The two main importance items in this ratio are Net Profits and Shareholders’ Equity.

ROE is the ratio that mostly concerns by shareholders, management teams, and investors. Most of the investors use this ratio to assess the profitability of the entity and for consideration whether they should buy shares from the entity or not.

However, there are many augment about this ratio to be used as the main indicator for investing decisions. The main reason is this ratio could be manipulated by the entity.

Why are the profitability ratios so important?

Profitability ratios are calculated and assess by both internal stakeholders and external stakeholders. These ratios are so important to management especially their performance that assigns the board of directors.

If you look at the ratios again and check with your entity key performance indicators, you might find most of them are on the list of KPI.

So that means to meet the performance that set, management needs to make sure the ratios run-up to the target. Mostly, these ratios are calculated and track monthly so that they could make sure they have enough time to fix.

Not only internal stakeholders, but also external stakeholders like bankers, creditors, investors, and shareholders are very serious about these groups of ratios.

If these ratios look good, the mean the entity might not find difficult to pay back the loan, and credits. Also, investors and shareholders will receive the stratify return on their investments.